Transaction Cost: Meaning, Examples and Two Solutions

The resolution of unfair distribution of wealth entails cost. This situation is referred to as transaction cost. This article explores the meaning of transaction cost and clarifies this concept by understanding how one’s actions can affect a significant number of people.

When controversy arises due to faulty transactions or market failures, the cost associated with it is usually unaccounted for or underestimated. People tend to overlook the significance of transaction costs hence incur expenses. Incurring unnecessary expenses can be avoided through ways that I will explain in this article.

But what is the meaning of transaction cost? If you search the internet to define this concept, you will notice no consensus on what it means. Korolyova devoted a paper in an attempt to explain it.

The Meaning of Transaction Cost

According to the Business Dictionary, a transaction cost is associated with exchanging goods or services and incurred in overcoming market imperfections. Market imperfections refer to the inefficient allocation of goods. Quick examples include communication charges, legal fees, informational cost of finding the price, quality, durability, and transport cost.

Components of Transaction Cost

Based on textbook definition, About.com lists the transaction cost components into

1) search costs,

2) negotiation costs, and

3) enforcement costs.

Search cost is the cost incurred in locating information for a possible exchange. Negotiation cost is the cost associated with forge an agreement on the terms of exchange, and enforcement cost is the cost of enforcing the contract.

Two Examples to Illustrate the Meaning of Transaction Cost

Turkcebilgi.com’s provides examples to illustrate the meaning of transaction cost as follows:

1. Commission to Brokers

In trading of goods, intermediaries or stock brokers facilitate the transaction between the buyers and sellers of investment tools like stocks, bonds, and mutual funds. The commission paid to the brokers by the buyers and sellers make up the transaction cost.

2. The Cost Associated in Buying a Banana

Here’s another simpler example. Consider the cost of buying a banana.

If you live in an urban area (unless you grow the banana yourself in the middle of the city), there are costs involved. You search for the banana that you want in the market, make a bargain on the price, and eventually bring the banana home. Hence, there are costs associated with search, bargaining, and transporting the banana to your home.

This simple example illustrate that aside from the price of the banana itself, you spend time, energy, and effort to find the banana that you prefer, expend energy in trying to bring down the cost of banana or even spend time in a queue if banana is scarce while in the market, and finally spending for transport and ensuring that the banana arrives from the market to your home.

All of these are transaction costs in buying a banana. It does not come to you automatically. You need to make an effort and spend for it.

Budget-conscious individuals tend to overlook this cost which if examined closely, tend to do things in a more costly way. Typically, these people tend to spend a lot of time haggling the prices of goods with the vendor whenever possible, walk around in circles trying to find the lowest price of a pair of shoes, dress, jewelry, among others. They forget the cost in time (opportunity cost), effort (all those energies equate to calories of energy from food to power the walk), and transportation cost to make to obtain the cheapest goods in town.

A Case of Hidden Transaction Costs in Misuse of Public Funds

negotiation

Based on the definitions provided above, transaction cost may be defined as the costs incurred in the instance of doing business.

Let me expand the discussion on this subject to cover a controversial issue: the politics of the resource allocation  I wrote about. The original transaction involves the misuse of public funds, which can be equated to a business’s failed market transaction. As the controversy rages on, lots of energies are expended to pursue the case.

I felt I need to write about the high cost involved in this issue and identified these costs as transaction costs that unnecessarily become a burden to taxpayers.

As the investigations transpire, and while concerned government agencies are hot on the heels of the alleged perpetrators of misused government funds, costs are incurred. Specifically, the transaction costs associated with the pursuance of this case include the following:

  1. Provision of security, escorts, housing, medical treatment, etc. to the whistleblowers,
  2. Going after the principal suspect and accessories to the crime,
  3. Hearings plus more security costs to keep the suspects unharmed,
  4. Attorney’s fees for both the defendant and the plaintiff,
  5. Privileged speeches and investigations to clarify issues or shed light on some lawmakers’ involvement,
  6. Time, money, and effort of people who go to the streets to protest the misuse of pork barrel funds, among others.

These are the transaction costs, but these costs can also be treated as externalities of government funds’ misallocation, particularly royalties from a natural gas sale. Unless the issue is resolved soonest, transaction costs incrementally go up.

Had not the major problem arose, no cost would have been incurred for its resolution. Had there been a fair distribution of wealth, a significant portion of which comes from natural gas, there would not have been any transaction costs to correct the unfair distribution of the proceeds.

How to Minimize or Get Rid of Transaction Costs

How could you reduce or eliminate the associated costs with any transaction? Here are two helpful tips.

Be Aware of Opportunity Costs Associated with a Transaction

Firstly, parties to the transaction should be made fully aware that there are costs involved in facilitating transactions. Trials for cases like the misuse of funds mentioned in the case discussed in the preceding section can drag for years. Hence, the case needs to reach resolution fast to avoid incurring more expenses.

It is obvious, and there is much evidence available to pursue the merits of the case. The problem appears that the defendants’ clever dodges (as they have enough money to spend) can keep the wheel of justice from moving swiftly. This process will entail more cost at the expense of the public.

If it is just a simple transaction of buying, say, a banana, buy that heck of a banana the first time you see it. If there will ever be a difference between the one you bought and the cheapest one available, you have saved time anyway. Time is more critical than those negligible savings on price. Five minutes of valuable time spent with your children or loved one is way too important to miss.

Engage an Arbitrageur or Intermediary

Another way to minimize transaction cost is to engage someone, an arbitrageur, who will do the transaction if it will be costly for you to do it. You will incur cost in the process, but it is lesser than what you or the seller will spend if both of you agree to engage that intermediary. It will be generally lesser to pay someone to do the work for you.

Prof. Daniel Russel explains how a specialized intermediary lessens transaction cost between parties of a transaction.

Professor Russel’s explanation of transaction cost and the importance of an intermediary.

At this point, you should already have a good grasp of the meaning of transaction cost. The next time you want to do business, think of the transaction cost that you will incur. Consider finding an intermediary who will work for you at lesser cost.

© 2013 October 9 P. A. Regoniel
Updated: 27 November 2020

Cite this article as: Regoniel, Patrick (October 9, 2013). Transaction Cost: Meaning, Examples and Two Solutions [Blog Post]. In Research-based Articles. Retrieved from https://simplyeducate.me/2013/10/09/transaction-cost/

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